How Risk Managers Should Define a Crisis, and Why It Matters: A Q&A With Dr. René Stulz

The global financial services landscape has been significantly altered by unpredictable – and sometimes unprecedented – events over the past 15 years. What steps can risk practitioners take to account for this uncertainty, build resilience, and be better prepared for future crises?

Friday, August 4, 2023

By Tod Ginnis


In the 21st century, it seems as if the world has bounced from one financial disaster to the next, with the Great Recession, the European debt crisis and the COVID-19 pandemic among the fiascoes leaving unforgettable imprints. But what do risk managers see as the essential qualities of a crisis? Moreover, how can they make coherent decisions for their firms with respect to predicting or responding to a market-altering event for which there is no historical precedent? 

Dr, René Stulz,
Everett D. Reese Chair of Banking and Monetary Economics and Director of the Dice Center for Research in Financial Economics, Ohio State University

Dr. René Stulz, the Everett D. Reese Chair of Banking and Monetary Economics and the Director of the Dice Center for Research in Financial Economics at Ohio State University, explored the current state of knowledge about crisis risk and its implications for risk management in a recent white paper. A past GARP Risk Manager of the Year and a member of GARP’s executive committee from 2002-2020, Dr. Stulz has been Director of the NBER’s Project on the Risks of Financial Institutions since 2005.

Recently, he shared his views with Risk Intelligence on the importance of assigning a meaning to crisis risk, the steps financial institutions can take to become more resilient, and how risk managers can best secure continuity for their organizations in uncertain times.

Risk Intelligence (RI): In your view, how should risk managers define a crisis, and why is this definition important?

René Stulz (RS): Crises should be defined as tail outcomes where the economy or the financial system no longer works normally. With this definition, firms cannot operate during a crisis the same way they did earlier. For instance, while a firm might have a contingency plan to raise funding in the capital markets, that plan may not be workable when capital markets are not functioning normally.

The definition of a crisis is important for devising stress tests and evaluating the relevance of potential scenarios. It is also important for calibrating risk models. If a firm’s risk appetite is to have enough capital 99 years out of 100, then that firm should have enough capital to survive several financial crises, since historically these crises occur more often than one year out of 100.

RI: How can risk managers help an organization prepare for unknowable crises, like the pandemic, that aren’t on the radar? Even risk managers can’t predict the unpredictable.

RS: That is where resilience is key. A firm can be organized like a Ferrari, which works spectacularly well when the road conditions are perfect, or an SUV, which can’t match the Ferrari’s speed, but can keep going if the road turns to mud. Resilience means that the firm has absorbing buffers, like a strong balance sheet.

The problem is that resilience is not free, so managers are faced with tradeoffs. How they resolve these tradeoffs depends on the likelihood of crises. If crises are exceedingly rare, resilience may be too expensive. However, I would argue that the likelihood of a crisis is generally high enough that building some resilience makes sense for many firms.

RI: So, resilience is a core strategy to protect against the fallout from potential crises. How can an institution become resilient enough to survive and thrive?

RS: In my work on COVID-19, I show that firms that had less leverage and greater cash holdings immediately before March 2020 fared better. This is the starting point for building resilience. A firm that runs with very high leverage cannot absorb large, unexpected shocks.

For many firms, operational resilience is crucial to address some types of crises. For instance, potential geopolitical crises that could cut off supply chains can be addressed through multiple sourcing, making supply chains more resilient to shocks.

RI: You mentioned that creating resilience isn’t free. How do you prevent going past resilience into extreme caution that restrains growth? And how do you convince management at public companies — often under pressure to maximize near-term profits — to sacrifice some of this performance in favor of resilience?

RS: Management of a firm and its board must figure out which risks are worth taking and which are not. A firm that is resilient may be able to take more risks. For example, a highly-levered firm might not survive a failed new project if it’s unable to meet its debt-service requirements. A less levered firm is in a better position to take on risky new projects and benefit from the potential rewards.

Resilience only makes sense if it increases firm value directly or indirectly by achieving objectives required by regulators. I am not arguing that one should convince management to do something against the interest of shareholders. However, a firm’s board must make sure that management is properly incentivized to consider risks that could have a devastating impact on the firm.

A deferred compensation plan, with payments tied to firm value, can help ensure that managers do not put too much weight on the immediate future.

RI: Do you believe the “massive” and “increasingly frequent” government interventions you note in your white paper have temporarily reduced the negative fallout of crises without solving the underlying causes? Can risk managers be confident in what they learn from past crises that featured intervention when in the future such interventions might not come or could prove less effective?

RS: I think it would be unreasonable to believe that there is no limit to the growth of central bank balance sheets and government debt. It is also the case that policies put in place to deal with shocks can have important unintended consequences that can affect businesses.

Risk managers should learn from past crises. But they should always be aware that the future may be quite different from the past.


Tod Ginnis is a content specialist at GARP. He is the author of a GARP blog that is aimed at early-career risk managers and professionals aspiring to earn their Financial Risk Manager (FRM) certification.


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